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"Yields on US government debt, which move inversely to prices, have surged during May and peaked this week, leaving holders nursing their worst monthly loss since December 2010. The immediate cause was concern that the Federal Reserve would soon start to "taper" its open-ended bond purchases - with far-reaching consequences for US debt markets and perhaps signalling a turning point in the 30-year Treasury bull market."

--Financial Times, 31 May 13

Sometimes I think that I'm living in my own separate universe. Here is what I believe to be true:

1. The Fed has, for the first time in its history, adopted an explicit employment target.

2. The policy tool being utilized to achieve this target is the expansion of the monetary base (the Fed's balance sheet) in order to expand the money supply (M2) in order to stimulate NGDP and business activity (which determines employment growth).

3. One way to express what the Fed is doing is that, because it cannot lower the nominal funds rate, it must reduce the real funds rate by raising inflation expectations from their current historically low levels.

4. Raising inflation expectations (which will require higher actual inflation, given the Fed's low credibility) will raise bond yields, and rising bond yields are therefore an important measure of policy success.

5. If the Fed decides to prematurely end or to reverse QE, inflation expectations will not be raised, policy will lose its stimulative effect, and NGDP and employment growth will be lower. Bond prices will remain low.

The conventional wisdom in the financial media today is that QE, by buying Treasury bonds, "artificially" raised their prices. The current wisdom is that ending QE would eliminate this bond price-support system, and bond yields would rise to their "normal" pre-Crash levels. Talk of ending QE is said to be bearish for bonds, which is 100% wrong.

Wouldn't it be wonderful if money-printing had the by product of lower bond yields? The more inflation that we had, the lower yields would go. Even though prices would be rising at, say, a 4% rate, investors would only demand a 10-year bond yield of 1.5%. We would then pay off the national debt by reducing its real value.

But the world doesn't work that way. Bondholders demand a real yield, and react negatively to the fear of higher inflation. When the Fed was creating double-digit inflation in the late seventies, bond yields were also in the double digits; there was no free lunch back then.

It is said that the Fed has been creating "artificial demand" for bonds, driving their prices above where the market would otherwise have them. But the Fed, despite its "massive" purchases, only owns a small proportion of marketable long-term government securities. The price of bonds is still set by the market, not the Fed. Rates are low because the market hasn't fully bought the story that QE will produce "normal" inflation in the future, perhaps because inflation is currently 50% below target.

My interpretation of the recent bond sell-off is that the market is beginning to see the glimmerings of higher growth sometime in the future, which would lead to higher short and long-term interest rates as the current "extraordinary accommodation" is withdrawn. In other words, QE3 has begun to work its magic, and as it does, bond yields should slowly rise to normal levels. This is consistent with rising stock prices, reflecting expected earnings growth, despite rising interest rates. As stocks go up and bonds go down, the equity risk premium should decline from its current historic highs.

There is a possible scenario in which inflation and growth resume their pre-Crash levels, the funds rate rises, and bond prices fall substantially. The size of the potential loss involved in a resumption of 3-4% bond yields is very substantial. Somebody out there would be clobbered, and there would be considerable financial turmoil. The key question is how big and how leveraged the carry trade is today, and who is doing it to excess.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Source: Why Bond Prices Are Falling